Understanding Stock Option Plans for Employees in Private Corporations

Stock options plans for employees are a powerful form of compensation and when used correctly, can be very effective to increase motivation, retention and attract new talent. Unfortunately, stock options plans for employees are commonly misunderstood by both the shareholders and employees due to their complexity.

If you’ve avoided them altogether, let this be your first step into the unknown. Or if you don’t fully understand your existing plan, then you are in the right place.

A stock option plan provides employees with the ability to purchase shares of a company in the future at a predetermined price known as the strike price. The ability for employees to participate in ownership and growth of the company can be a motivational tool that aligns the interests of employees and owners. When granting stock options, many factors need to be considered for the options to be valuable and effective.

Employee Selection - Careful consideration should be made when choosing which employees should be given the option to participate in a stock option plan. Long term key employees in management roles who can directly impact the growth and performance of the business are ideal candidates. They should be in a role which allows for significant decision making, such as senior management or executives, as they can most significantly impact operations.

Vesting Period - Typically, employee stock options are not immediately available to the employee to be sold, exercised or transferred. The time between the grant date and the date when control of the options transfers to the employee is known as the vesting period.

Picking your vesting period is important because, if done correctly, it provides incentive for employee retention as well as alignment with medium- and long-term goals of your business. If the period is too long, it may seem out of reach - while if it’s too short then they may exercise the options and leave the organization. If you desire to reward past work of current employees, you may consider having a portion of the options that vest immediately.

Strike Price

The strike price is the predetermined price by which the option can be purchased in the future. For example, you may grant options to buy shares at $100 per share in the future. The strike price would then be $100. Most commonly, the strike price is set at fair market value at the time of the option grant unless there is a desire to reward past service by allowing the strike to be set at less than the current value. Determining the strike price is important as it assigns the value of the option as well as determines the tax treatment.

Number of Options

The number of share options granted should reflect the overall compensation you are prepared to give that individual employee. The total options combined with the strike price will add up to the total value offer through the options. It is important to take into consideration what the overall shareholdings would be if all the options were to be exercised in the future. A large influx of the number of shares issued by the corporation will have a diluting effect on shareholders who do not have share options. A common range for the number of stock options is 5 percent to 15 percent of the total share count, with 10 percent being used in many cases.

Tax Treatment

The company issuing options is unable to take any deduction for tax purposes for the value provided, but the employee will have a tax liability in the future. No reporting is required by the employee when the options are granted, however, there is a deemed benefit income inclusion when the shares are sold by the employee (Canadian private corporations) or when exercised (public corporations).

The deemed benefit is calculated as the difference between the strike price and market value on the exercise date. A 50-percent reduction of the deemed benefit is available unless the options are granted “in the money” and they are sold within two years of the exercise date. This gives rise to the tax incentive not to issue “in the money” options. When the strike price is lower than the market price on the grant date, those options are in the money. This refers to the favourable share price for the options on the day they were granted.

The eventual sale of the shares will also be a taxable transaction in the form of capital gains. Capital gains are 50 percent taxable and are calculated as the difference between the selling price and the cost base of the shares. For shares that were acquired from an option, the cost base will be equal to the market value on the exercise date.

Example: Options Timeline

In the example above, the options were not issued in the money so the 50-percent deduction on the employee benefit is available. When the employee sells the shares, they would include a $7.50 [15 x 50 percent] taxable benefit and a $12.50 [25 x 50 percent] taxable capital gain into income.

Administration

With a new compensation plan comes additional administrative practices to maintain the plan. The nice thing about stock option plans for employee in Canadian controlled private corporations is there aren’t withholding tax requirements. Taxes are to be self assessed by the taxpayer in the year the shares are sold, based on the amounts described in the previous section.

A common occurrence with share options is that an employee doesn’t have enough cash to pay to exercise the options. In this case, it is possible for the corporation to issue shares to the employee equal to the incremental increase in value of the options. This is known as a cashless exercise.

Example: Cashless Exercise

1,000 Number of Stock Options

$ 125 Strike Price

$ 140 Market Price on Exercise Date

$ 140,000 Market Value of Shares (1,000 x 140)

$(125,000) Cash Required to Exercise (1,000 x 125)

$ 15,000 Value of Options

Normally under these circumstance,s the employee would need to pay $125,000 cash to exercise the options and would receive 1,000 shares with a market value of $140,000. The options provide the employee additional value of $15,000.

Alternatively, if the employee does not have $125,000 cash, they could opt for a cashless exercise if such a feature is provided for in their option agreement.

This would allow them to accept shares equal to the value of the options without paying any cash. In this case the value of the options is $15,000, represented by the increased market value compared to the exercise price. For a cashless exercise, the employee would not have to pay anything to exercise the options but would only receive 107 shares (15,000 / 140) with a market value of $15,000. The options have still provided the employee with additional value of $15,000 but they end up with fewer shares to participate in future growth of the company

There will also be cases where an employee resigns, retires or is terminated while there are options in the vesting period. Agreements should be put into place regarding such events to indicate triggers for cancellation of options. Other events such as majority change in ownership of the corporation or mergers with new corporations can also affect the timing and status of share options.

Once these factors have been considered, you will be prepared to implement a stock option plan that meets your objectives. This will enhance employee motivation and satisfaction through a superior compensation model which provides the rewards of ownership to key employees.

Contact Wayne Paproski, CPA, CA, or Tait Nystuen, CPA, at 306.790.7900.